Posted by Tasnim Ahmed
April 14, 2021 | 5-minute read (834 words)
A special purpose acquisition company—more often simply referred to as a SPAC— is a shell company made by investors solely to raise more capital by way of an IPO in order to acquire another business, in effect making it public without going through the traditional initial public offering process. Many businesses are using this route to generate cash for when they need to make an acquisition, diversify their portfolios or just keep plans ready to grow. But companies nowadays most often do it to altogether skip the IPO route. Consider that a planned IPO for any company takes a minimum of six months of approvals and meeting compliance requirements. Then there may be rumors and industry grapevine talk that affect the IPO’s performance, causing it to underperform compared to analysts’ forecasted performance.
Enter a SPAC proposal. A SPAC IPO needs relatively little time to float, entails fewer compliance hurdles and can be quickly assimilated to the parent company that might have floated it in the first place. So how does it work?
Consider this scenario: Company A needs an infusion of funds to grow. Until now, A has achieved growth through investors, and the next logical step is to take it public. However, there is a certain amount of risk involved in a traditional IPO. Undervaluation is the main scourge for business backers, along with potentially ceding control of company shares. So, some companies opt to make a shell outfit, which may or may not share their name, and to raise capital on their own on the open market. These so-called SPAC companies might be directly or indirectly related, considering how much information is available on the open market about them.
But one thing is certain: These companies state from the very beginning that their only asset is the “capital” raised. The money, once collected, is parked in an interest-bearing account until it has been used to achieve the purpose for which it was raised. Company A, which created the SPAC company we will call ABC, now has the option to merge itself with SPAC company ABC or to force SPAC company ABC to acquire it. This saves a lot of time versus a traditional IPO and reduces the uncertainties of raising capital.
SPACs are usually backed by billionaires, hedge funds, capital companies, high equity institutions and the like. Why? Because people investing in the IPO usually do not know where the money is going to be used. Individuals or institutions with a great track record are therefore more successful in raising funds for the speculative investment, earning SPACs the sobriquet of “blank check companies.” Once the money is raised and placed in an interest-bearing account, the company will either search for a company to acquire, or if it is privately raised, the SPAC will try to merge itself with the original. In any case, SPACs generally have two years to either get a deal or to liquidate with investors getting their money back with interest.
SPACs are a hot trend in the financial world now because they are perceived as taking some of the volatility of the market away with some semblance of order put back in. Smaller companies went this route much sooner because they couldn’t raise money through conventional methods. A SPAC merger allowed an entity to go public fast and to get the required capital influx while also allowing the company to negotiate its own value with the SPAC.
Even though SPACs have become a very popular mode of raising capital, they are not without risk. For example, a target company for acquisition may be rejected by the SPAC’s investors. And the majority of SPAC investors are usually functioning blind, with no knowledge as to who has floated it or is handling it. Some critics are even of the opinion that SPACs are not properly vetted by industry watchdogs like other IPOs and therefore fall into a legal grey zone.
The final catch is that not all SPACs launched in the past few years have earned the high returns initially espoused, nor is the time limit of two years always sufficient to get a solid deal with great returns and minimal risk. Advisory firm Renaissance Capital reported that in the last five years, the average yield from SPAC mergers was less than the average return of a traditional market IPO. Having said that, SPACs are here to stay. With powerful business leaders and high net-worth individuals floating and backing SPACs, coupled with publicity surrounding some of their biggest successes, SPACs aren’t likely to wane in popularity anytime soon.
If you take an account of this year so far, SPAC Insider reports that 276 SPACs have held an IPO and collectively raised close to $90 billion in gross proceeds, exceeding last year’s record in only three months. The highest valuation among SPACs in 2021 has been Lucid Motors at $11.75 billion.